In the late hours of Friday, BP (NYSE:BP) investors found out that BP's appeal to the US court regarding compensation claims was blocked because the court didn't agree with BP that many of those claims were fraudulent. Basically, a couple years ago, BP drew out a formula to determine who would be qualified for the settlement money and who wouldn't, and the court decided that the company can't change "its mind" about the settlement after the fact. BP argues that there are a lot of people who fit the company's formula; however, they shouldn't have been included in the settlement.
The problem stems from the fact that BP's formula to determine eligibility was not specific enough. BP was willing to give money to everyone who had a business in a given geography (there was a list of eligible zip codes), suffered declines in their business shortly after the oil spill (determined by the revenues and profits between 2007 and 2010), and/or suffered extra expenses as a result of the oil spill, such as medical expenses. There could be many people who live in an affected geography, saw declines in their business but their declines might be a result of something completely irrelevant to the oil spill; however, they would still get money from the settlement.
BP could go to court and fight each case one-by-one to determine who truly deserves to get money from the company. This would present a very lengthy and expensive process for both parties involved. Instead, the company decided to take the route that would prove good faith by offering one large settlement and including many people who may or may not be affected by the spill. Basically, the company didn't think there would be many claims from those that were not actually affected by the spill. Of course, BP couldn't think of the fact that there are a lot of shark-like lawyers who will attack whenever they sniff some blood. Many lawyers in the affected region were looking for people to include in their case, in order to squeeze as much money from BP as possible.
Looking back, BP realized that its original settlement and formula was a huge mistake and wanted to change things back to more reasonable levels, but the US court decided that it is too late for BP to change the settlement it agreed on. BP provided the court with some cases it believes to be fraudulent; however, the court didn't agree that those cases warrant changing the settlement. The court members seem to believe that BP can defend itself when a claim is truly fraudulent.
So what's going to happen now? The latest estimates range from $30 billion to $90 billion. When all is said and done, if BP ends up paying a sum closer to higher-end estimates, this can hurt the company's finances badly. Even a company as large and profitable as BP would see its very survival under threat if it were forced to pay around $90 billion to the plaintiffs.
So far, BP spent $14 billion on cleaning up the ocean and surrounding shorelines, $11 billion to affected businesses and people and it was estimating to pay another $17 billion for the remaining settlements, charges and damage estimates. If we look at BP's balance sheet we find that the company has about $30 billion in cash and liquid assets, $26 billion in long-term investments, $105 billion in current assets and $311 billion in total assets. After removing the total liabilities of $181 billion, the company still has equity of $130 billion. Basically, BP has enough assets to cover even the worst case scenario. Furthermore, BP is expected to generate $5.17 per share in net earnings next year, after earning $4.48 this year. At this point, the company can either sell assets, take-on additional debt or issue more stocks to pay off the bill. If BP sells some of its liquid assets and adds it to the existing cash, the company can cover most of the $90 billion bill. If the company takes-on more debt, its current cash flow generation can easily get it new debt in favorable terms and low interest rate. If BP issues new shares to pay-off the bill, the company can start buying back its shares in an accelerated manner in order to reduce the share count to today's number, so that the damage of the investors is limited. Today, BP's market value is about $153 billion. If the company issued new shares worth of $50 billion, this would result in a dilution of 33%; however, the company's current cash generation would allow it to buy those shares back within 4-5 years (even sooner if the share price falls sharply as a result of dilution).
Even in the worst case scenario, BP has enough assets or resources to cover the bill. A $90 billion bill would surely hurt BP badly, but the company would still survive the hit and move forward, as long as we don't see another disaster like the one in 2010. I'm surprised that the British government hasn't been putting much of its weight on the issue. If the British government was involved in the case, the US government wouldn't have been so tough on BP.
BP's case will continue on for a while and we will not see the results anytime soon. The investors should understand that BP's situation is full of uncertainties and no one really knows how much more money the company will have to spend before it can put all this behind. This is not to say that BP is a bad investment though. The company still carries a lot of value and potential; however, this is definitely not the safest investment there is. A little caution and some diversification would definitely help a lot.
Disclosure: I am long BP, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.